Q&A: Simon Powell on China's coal-bed methane prospects

With coal-bed methane garnering more attention and investment in China, CLSA’s Simon Powell sits down to dispel some of the hype and explain how the sector will likely unfold in the years ahead

To what extent is coal-bed methane a viable industry in China on its own? Is what we’re seeing now mostly due to outside support, say from the government, or is it motivated more by an urge to get away from other energy sources that are now maybe more problematic, like coal?

Coal-bed methane in China was never going to be easy. And people who thought it was the same kind of coal-bed methane that we saw in America or Australia were sadly mistaken from an investor point of view. Coal-bed methane in China is pretty difficult. The coal is extremely wet, and the porosity is really low. And what you find is that for a lot of coal-bed methane producers, all they produce for the first few years is water. So there’s been significant amounts of de-watering, and as far as I can see very few coal-bed methane producers have produced any meaningful amounts of coal-bed methane.

So what’s been behind the drive of recent years?

Well I think there’s a few things. One, when you look at China’s overall demand for gas versus its ability to supply that gas domestically, there’s a shortfall. So that’s what the push has been, and that’s why they put in subsidies for both shale and coal-bed methane. But those subsidies haven’t resulted in huge amounts of volume.

So are there any dominant forces in the coal-bed methane industry right now in China?

Well PetroChina is probably the biggest player. But they treat it not as a commercial business, they treat it as almost research and development, so they’re producing very little volume. PetroChina’s probably the most dominant, then really followed by plenty of independents.

Provided that the industry ever actually finds its feet, is there an opportunity there for more private players than in other energy sectors?

Yes, there is. At the moment in fact, in upstream gas it’s in coal-bed methane where independent, non-SOE players can currently play. But let’s step back: The coal-bed methane industry in China has had a very long history. Some of the earliest production-sharing contracts that were offered were taken up by Enron, that’s how old the industry is. And many – like Enron, Texaco, ConocoPhillips – geologically and financially it was very hard to make any kind of satisfactory returns. I think that it’s quite telling how the majors couldn’t make it work. The Chinese have been keen to absorb technology from Western companies in terms of lateral drilling and inseam drilling, and so they opened up production sharing contracts (PSCs) to independent companies to encourage that technology to come in. And that’s what’s been happening.

So there are listed companies like Green Dragon Gas, or Far East Energy, or Sino Gas and Energy, or Sino Oil and Gas, and there are unlisted companies like Asian-American gas. You know, the reserves from the coal-bed methane point of view are quite large, so the prospective resource is large. So the size of the prize for the Chinese government was very large, and remains very large. The challenge is just that the technology and the geology makes monetizing that, or actually releasing that gas very difficult.

That sort of raises two main questions: One, how suited is China’s geography to practical coal-bed methane, and what are the key technologies, or maybe workforce experience, that China lacks to take advantage of it?

Well I think, answering your second question – and it applies to shale as much as it does to coal-bed methane – one of the things that made the shale gas and coal-bed methane industries move so quickly in North America and to some extent in Australia, was a very vibrant oilfield service industry. In other words, if I’m a little independent player and I don’t own my own rigs, I want to be able to ring someone up and subcontract them to come in and start drilling holes for me, right? We don’t have a vibrant mom and pop industry that can drill holes the way that we had in North America. So, I think that’s one of the things that’s holding them back a little bit. I think as well, even though natural gas prices have risen and we’re now at six or seven dollars an Mcf [thousand cubic feet] at the wellhead, we potentially need to see more gas price increases to make coal-bed methane more economically viable.

Until the mid-90s I believe natural gas was shrinking as an energy source, but it hit 5% of the total at the end of 2011. What kind of portion of total energy use for China could you envision it eventually accounting for?

Well, it’s hard to say. The best thing to do is to look at other countries. So in OECD countries, natural gas is north of 20 percent of total energy mix. The rest of Asia, it’s potentially ten percent. So I think it would be very easy for total energy mix to be ten percent, and go higher than that. The big question is: Will China ever generate meaningful amounts of electricity from natural gas, or from methane – you know, coal-bed methane or natural gas or shale gas. Because with coal prices having softened substantially, and gas prices having risen and electricity prices remaining flat to declining on a wholesale basis, it currently as it stands is not particularly economic to generate electricity using gas.

You hear about illegal coal mines, I suppose the capital needed for starting up a coal outfit and the manpower is vastly lower, and maybe the technological knowhow too.

I don’t know about technological knowhow. I think the Chinese are loathe to give up on coal as a power generation source because even though they want to improve the environment, they still have an awful lot of coal, and coal mining still employs an awful lot of people. So I think that the coal-bed methane industry has a future. It’s just a difficult future from a ‘return on capital employed’ kind of basis.

But the challenge for all these producers is to get to a stage where they’ve got scale. I think this is something else that’s very important as well – I think the original production sharing contracts that were written for coal-bed methane were really cut and pastes from conventional gas PSCs, and coal-bed methane PSCs don’t lend themselves to those kinds of production sharing contracts. What I mean by that is a traditional natural gas PSC is designed that you spend a huge amount of money up front drilling one or two big gas wells, and then you hit the gas, and the gas flows for the next 15 years.

A coal-bed methane play you have to drill a well every 20 days, and the decline rates from coal-bed methane well are much steeper than for natural gas wells. So what it means is, if I’m a small independent player, I need to get approval to spend capital expenditure, but I don’t want to be having a meeting with my PSC partner every 10 days to try and get approval to spend money. I need to just be able to spend money as and when I like. You need a different type of PSC for coal-bed methane in some ways, so I think China’s production sharing contract regimes don’t lend themselves to shale, gas, or coal-bed methane at this stage.

I also think that the question of ownership of hydrocarbons is also a difficult issue. If you ever look at a coal-bed methane PSC, it’s very prescriptive. What it will say is you’ve got the right to explore in coal seam number nine and coal seam number 12, whereas in North America you own 1,000 acres in Wyoming or whatever, and you own everything from the grass downwards. Whereas in a Chinese context, it’s unclear whether you even own the grass. See what I mean? So these are some of the challenges and nuisances.

What are they key factors that could influence coal-bed methane’s role in China?

I think the most important thing is to keep your eye on gas price reform. So we’ve had two price increases in two years, we’ll get another 40 cents’ increase in July of next year, and it’s all about linking natural gas prices to oil prices, and creating a better pricing mechanism for natural gas. I think the other important thing is that of course some people are expecting an awful lot of shale gas activity, and again I think the geological challenges of shale gas activity are not to be underestimated, either. And so I think shale will be a disappointment in some ways, as coal-bed methane has been. That isn’t to say that there won’t be some viable shale activity like we’re seeing in Fuling [in the Sichuan Basin] with Sinopec, but I think people need to be cautious not to expect too much. ♦

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